Erasmus School of Economics
Msc. Accounting & Control
Master Thesis
Equity-based compensation as incentive for CFO’s fiduciary and managerial performance
Jaap Pieter van Stam
333455
Date: 31 December 2015
Supervisor Co-reader
drs. R.H.R.M. Aernoudts dr. C.D. Knoops
Department of Business Economics Department of Business Economics
Erasmus School of Economics Erasmus School of Economics
Erasmus University Rotterdam Erasmus University Rotterdam
Abstract
This study links CFO’s performance to equity based compensation and investigates the effectiveness of equity as an incentive for a CFO. Besides, this study distinguishes managerial duty and fiduciary duty as the two elements of the total duty of a CFO. The analysis is based on two databases of “S&P 1500” firms with CFO performance measures and CFO compensation data for the years 2006 to 2014. The results indicate a significant positive relation between equity compensation and CFO’s managerial performance, but shows no relation between equity compensation and CFO’s fiduciary performance. A regression indicates that CFO’s fiduciary and managerial performance are not associated with CFO’s total performance.
Executive Summary
Several corporate failures heated up the debate concerning executive compensation and financial reporting quality. The provision of proper incentives is crucial in order to stimulate the concerned executives such as the CEO and CFO and align them with the goals of the shareholders. Equity based compensation is widely used as an incentive for CFOs in order to maximize their performance in the line of the organisation. In this typical principal-agent setting, performance measurement plays an important role. However, previous research on CFO performance measurement is scarce. Hoitash, Hoitash, & Johnstone (2012) and Indjejikian & Matêjka (2009) analyse the CFO performance and divide this into the managerial and fiduciary performance. Prior studies of proponents (e.g. Grossman & Hart, 1986; Hölmstrom, 1979; Jensen & Murphy, 1990) and opponents (e.g. Armstrong, Larcker, Ormazabal, & Taylor, 2013; Bergstresser & Philippon, 2006; Cheng & Warfield, 2005; Cheng & Farber, 2008) of equity based compensation can be pointed out clearly, but do not provide consistent results. This thesis links CFO performance to CFO equity based compensation and aims to answer the question: “What is the influence of equity based compensation on the managerial and fiduciary performance of the CFO?”.
The analysis is based on two databases of “S&P 1500” firms that are fused together into one database with CFO performance measures and CFO compensation data. This results in an initial dataset of 15936 records of 2314 unique firms for the years 2006 to 2014. The statistical analysis uses an Independent T-test, One-Way ANOVA and Ordinary Least Squares regression, which can all be found in the Appendix. The results indicate that the presence of equity in a CFO’s compensation package has a positive effect on CFO’s managerial performance, but no effect on CFO’s fiduciary performance. Moreover, an increase in the proportion of equity compensation has a positive association with CFO’s managerial performance indicating a linear effect, but no association with his fiduciary performance. A regression indicates that the CFO’s managerial and fiduciary performance are not associated with CFO’s total performance. This undermines the assumption that CFO’s total duty consist of only a managerial and fiduciary duty (Hoitash, Hoitash, & Johnstone, 2012; Indjejikian & Matêjka, 2009). The association between the proportion of equity compensation and CFO total performance is not significant either. This means that the influence of equity in a compensation package on CFO performance is only significant for the managerial performance of the CFO, but not for the fiduciary and total CFO performance. These findings contribute to the discussion with regard to equity compensation, yet remain inconclusive.
Regarding the principal-agent setting, one could conclude from this study that equity based compensation only partially stimulates executive motivation, namely regarding managerial performance.
From an internal control point of view, this implies that equity compensation is highly ineffective to stimulate fiduciary performance. From the perspective of SOx initiators and enforcers, this means that there is still too much reliance on financial performance and too little on fiduciary performance.
These conclusions are less in line with current literature than expected. Possibly due to undermining a fundamental assumption that CFO’s total performance is the sum of managerial and fiduciary performance (Hoitash et al., 2012; Indjejikian & Matêjka, 2009). However, this study shows that the measurement of CFO performance should be more sophisticated than the variables used in this study, since a regression indicates that CFO total performance is not associated with either managerial performance or fiduciary performance.
Content
Abstract 2
Executive Summary 3
1 Introduction 8
1.1 Research question 9
1.2 Managerial relevance 9
1.3 Scientific relevance 10
1.4 Outline 10
2 Literature review 12
2.1 The CFO within the governance structure 12
2.1.1 Agency theory 12
2.2 Control systems 13
2.2.1 Incentives 14
2.2.2 Compensation 15
2.2.2.1 Monetary compensation 15
2.2.2.2 Empirical evidence on monetary compensation and performance 16
2.2.2.3 Equity compensation 16
2.2.2.4 Empirical evidence on equity compensation and performance 18
2.2.3 Performance measurement 19
2.3 CFO responsibilities 19
2.3.1 The fiduciary responsibility 19
2.3.2 Empirical evidence of the fiduciary responsibility 20
2.3.3 The managerial responsibility 21
2.3.4 CFO total performance 22
2.3.4.1 CEO performance 22
2.4 Summary and conclusions 24
3 Hypotheses 25
3.1 Conceptual framework 25
3.2 Hypothesis development 26
3.2.1 Hypothesis 1 27
3.2.1.1 Libby boxes 27
3.2.2 Hypothesis 2 28
3.2.2.1 Libby boxes 28
3.2.3 Hypothesis 3 29
3.2.3.1 Libby boxes 29
3.2.4 Hypothesis 4 30
3.2.4.1 Libby boxes 30
3.3 Measurement of variables 31
3.4 Internal validity, external validity and construct validity 31
4 Methodology 33
4.1 Data collection 33
4.2 Variables 33
4.3 Sample 35
4.4 Testing the hypotheses 37
4.4.1 Testing hypothesis 1 37
4.4.2 Testing hypothesis 2 38
4.4.3 Testing hypothesis 3 38
4.4.4 Testing hypothesis 4 39
5 Results 40
6 Conclusion 45
6.1 Discussion 45
6.2 Practical implications 46
6.3 Limitations 47
6.4 Future research 48
7 References 50
8 Appendix 55
8.1 Overview of previous research 55
8.1.1 Literature with the focus on corporate governance and control systems 55
8.1.2 Literature on the relation between monetary compensation and performance 55
8.1.3 Literature on the relation between equity-based compensation and performance 56
8.1.4 Literature on the CFO performance 57
8.2 Additional mutual relations of deciles 59
1 Introduction
In reaction to several corporate failures, recent regulations have been aimed at strengthening financial reporting and governance practices such as executive compensation. The two executives that are focal points of these new regulations are the CEO and CFO. Previous research has been performed regarding CEO performance and incentive systems (Banker, Potter, & Srinivasan, 2000; Ittner, Larcker, & Rajan, 1997; Jensen & Murphy, 1990). Even though the function of the CFO is not less important, CFO performance and incentive systems are much less investigated in current research.
The CFO is expected to act on behalf of the shareholders of a firm, since they are legally the owner. This is where the elements of classical agency theory become visible (Jensen & Meckling, 1976). “If both parties, the CFO as agent acting for the principal, i.e. the shareholder, are utility maximizers, there is good reason to believe that the agent will not always act in the best interests of the principal” (Jensen & Meckling, 1976 p.5). The contractual relation between the principal and agent should be constructed in such a way that it provides appropriate incentives for the agent to make choices which maximize the principal’s welfare (Jensen & Meckling, 1976). The effort of the CFO should be aligned with the goal of the company and thus enhance the creation of shareholder value.
To achieve the goal of maximizing shareholder value, the most effective manner is to maximize long-term value rather than managing for short-term earnings (Rappaport, 2005). Several studies find evidence that it motivates managers to make value-maximizing decisions when their compensation is tied to firm performance (e.g. Harris & Raviv, 1979; Hölmstrom, 1979) and that the form, rather than the level of compensation, is what motivates executives (Mehran, 1995). Although several studies argue that it is not optimal to fully base compensation on the firm’s stock price (Paul, 1992; Sloan, 1993), Jensen and Murphy (1990) suggested equity-based compensation in order to motivate a manager more effectively (Jensen & Murphy, 1990), since the manager is basically exerting effort for his own utility, which should minimize the agency problem.
However, CFO compensation is also highly dependent on the financial reporting system, which is controlled by the CFO himself (Indjejikian & Matêjka, 2009). Since many CFOs are awarded bonuses based on what is effectively self-reported performance, this is a questionable aspect of CFO performance measurement (Indjejikian & Matêjka, 2009).
Prior research distinguishes with regard to the role of the CFO within the firm as consisting of two separate duties (Hoitash et al., 2012; Indjejikian & Matêjka, 2009). Firstly, the CFO has managerial duties and contributes to decision making such as any other senior manager. Secondly, he or she must report on the firm’s financial performance, keeping the greater good of the firm and subsequently the shareholder in mind. This is described as the fiduciary duty[1]: “the production of financial statements that fairly represent the financial condition of a firm” (Indjejikian & Matêjka, 2009 p.1062). The priority of the responsibilities of the CFO can influence the design of compensation contracts and in particular the choice of performance measures in a financial executives’ compensation plan (Indjejikian & Matêjka, 2009).
1.1 Research question
The main problem is thus the alignment of the CFO’s goals with the goals of the shareholders, which, according to the literature, can be influenced by including firm’s equity in the CFO’s compensation package. It is often not taken into account that the CFO actually has two responsibilities: a fiduciary duty and a managerial duty. This thesis focusses explicitly on the performance of the CFO with regard to the fiduciary and managerial responsibility. This leads to the following research question:
What is the influence of equity compensation on the fiduciary and managerial performance of the CFO?
1.2 Managerial relevance
A number of major accounting scandals increased the attention on reliable corporate governance, with the enactment of the Sarbanes-Oxley Act as a result. This United States federal law set new requirements for US public firm boards and management on July 30, 2002 (US House of Representatives, 2002). Section 302 and 404 are considered as the elements of SOx with the most impact, since it requires the management and external auditor to evaluate the firm’s internal control on financial reporting. The outcome of the evaluation may include an ‘Internal Control Material Weakness’, which means that an internal control is so deficient, that it could lead to material financial misstatements. Therefore, since the introduction of SOx, the duty of a CFO is even under more scrutiny. Besides, the findings of this thesis are of interest to the initiators and enforcers of SOx.
The results of this study are relevant to shareholders and boards of directors, since it provides insight into the effects of equity compensation in the executive compensation system. Ultimately, the board of directors is the entity that constructs the incentive systems for the top executives on behalf of the shareholders. This thesis clarifies the impact of equity compensation on CFO performance, which may be useful for decision making of the boards of directors regarding the incentive systems for the CFO. The shareholders relinquish the management of the firm to the board of directors, and they are thus interested in decisions that affect the performance of their asset.
1.3 Scientific relevance
This thesis on compensation regarding the CFO performance is related to other studies that explicitly distinguish the CFO fiduciary and managerial duty. There is evidence[2] that firms decrease emphasis on the managerial duty in the post-SOx years (Indjejikian & Matêjka, 2009), which can be interpreted as an increased emphasis on the fiduciary performance. Other research finds a negative relation between CFO bonus compensation and disclosure of an internal control material weakness, which can be seen as a measure for fiduciary performance (Hoitash et al., 2012). By explicitly distinguishing these two CFO responsibilities, this thesis provides for clarification in a research area where theoretical and empirical evidence is scarce. Regarding the CFO’s fiduciary and managerial duty, this thesis extends prior studies by examining the relation between fiduciary and managerial performance and CFO’s compensation incentives (Hoitash et al., 2012; Indjejikian & Matêjka, 2009).
In addition to the direct link between CFO compensation and CFO performance, this thesis considers the influence of equity as a compensation component, of which the aim is to increase goal alignment between the CFO and the company. Regarding equity as executive compensation, this thesis extends studies that consider equity as a more effective compensation system (e.g. Jensen & Murphy, 1990), and studies that argue that it is not fully optimal to use equity as the only compensation component (e.g. Paul, 1992; Sloan, 1993). A considerable amount of literature investigated the association between equity compensation and financial misreporting, but the results have been mixed (Armstrong et al., 2013; Bergstresser & Philippon, 2006; Erickson, Hanlon, & Maydew, 2006; Larcker, Richardson, & Tuna, 2007). This thesis aims to provide more clarity with regard to the relation between equity incentives and, not only taking misreporting into account, but the fiduciary and managerial role, more specifically CFO performance in its entirety.
1.4 Outline
This thesis consists of six chapters that each contain a part of the thesis. In chapter 2, relevant previous literature is reviewed and a conceptual framework is constructed. In chapter 3, the hypotheses are presented, discussed and specified. The sample and variables and methodological issues are discussed in chapter 4. In chapter 5, the results are presented and in chapter 6 draws a conclusion along with a discussion of the results, limitations of the thesis and raises ideas for future research. Chapter 7 contains the references and chapter 8 is the Appendix.
2 Literature review
The main concepts that are related to the research question are discussed in this chapter to provide a comprehensive overview of the different models, definitions, and empirical evidence regarding the association between CFO compensation and CFO performance. The goal of this literature review is to indicate the importance of the research question by identifying gaps or controversies in previous research and critically reviewing the methodologies that are used.